I'm 62 With $1.6 Million in My 401(k). Should I Convert $160,000 Per Year to a Roth IRA to Avoid RMDs?

Converting your 401(k) to a Roth portfolio will allow you to entirely avoid RMDs. This is a legitimate form of tax planning. However, often there's a difference between whether you can do something and whether you should; whether it's allowed, and whether it's in your long-term best interest.

For example, say that you're 62 years old. You have $1.6 million in a 401(k). If you convert this portfolio to a Roth IRA 10% at a time, you can avoid required minimum distributions on your $1.6 million. However, particularly for households approaching retirement, a Roth conversion may result in a net-loss. There's a chance that the tax costs of making those conversions will outweigh the tax benefits of avoiding minimum distributions.

Here are some things to consider. Also consider matching with a fiduciary financial advisor who can help you weigh your options.

What Are RMDs?

Starting at age 73 (or 75 starting in 2023), the IRS requires you to begin taking regular, minimum withdrawals from every pre-tax retirement account. This includes 401(k) and traditional IRA portfolios. These withdrawals are known as RMDs.

The exact amount you must take is based on the portfolio's total value on January 1 and your age. You have until the end of each year to make the withdrawal, so you can take your minimum distribution in any amount at any time by or before December 31. If you don't take your minimum distribution, the IRS charges a tax penalty typically worth 25% of the amount not withdrawn.

Like all withdrawals, you will have to pay ordinary income taxes on your minimum distributions. This can create a problem if you need less money than your minimum distribution, such as if you have other sources of income or multiple retirement accounts. In that case, you might prefer to leave the money in place for tax-free growth rather than pay income taxes on an unnecessary distribution.

One solution to this is converting your pre-tax portfolio to a post-tax Roth account, because the IRS does not require minimum distributions on Roth IRAs.

How Do Roth Conversions Work?

A Roth conversion is when you move money from a pre-tax retirement account, such as a 401(k), to a post-tax Roth IRA.

Mechanically, the process is typically simple. You open a Roth IRA with a qualified brokerage. Then, you can instruct your plan manager to transfer the assets from your pre-tax portfolio to the Roth IRA, or you can withdraw the money and assets personally and deposit them in the new account. If you move the money personally, you have 60 days to deposit it into the Roth portfolio.

There is no limit on how much money you can convert each year, nor is there a limit on how often you can do so. But tax implications may make you think twice about how much you convert in any given year.

A financial advisor can help you weigh the tradeoffs to determine if a Roth conversion is the right strategy to maximize your retirement income. Get matched with a financial advisor today.

Tax Implications

You must pay income taxes on the full amount that you convert. Any amount of money that you convert to a Roth IRA will count toward your taxable income for that year. For example, if you convert $160,000 from your 401(k) to a Roth IRA, you will add that $160,000 to your taxable income for that year. If you are under age 59 1/2, you will need the cash on hand to pay that tax bill. If you are older, you can take the money for taxes from your retirement account. In all cases, this will reduce your potential savings and investment capital.

Once you make a Roth conversion, these assets will continue to grow tax-free. For qualified retirement distributions, you will also pay no taxes at all on this money when you withdraw it later in life, and it will not count toward your overall taxable income.

A staggered Roth conversion is often effective at reducing the overall impact of conversion taxes, because you can manipulate your withdrawals to prevent yourself from climbing into higher tax brackets to some degree. Take our example here. Setting aside other sources of income for the year, say that you want to convert $1.6 million from a 401(k) to a Roth IRA. You could either do so in a lump sum in one year, or in $160,000 transfers over 10 years (not accounting for portfolio growth during that time). In this hypothetical instance, your income taxes would be around:

Lump Sum Transfer: 

• Annual Taxable Income $1.6 million

• Total Taxes $547,208

Staggered Transfer:

• Annual Taxable Income $160,000

• Annual Taxes $28,476

• Total Taxes $284,760

By converting your money in stages, less of it is exposed to the top tax brackets, reducing your overall payments.

If you are making staggered conversions near your retirement age, you must keep this in mind: When you convert money to a Roth IRA, the five-year rule applies. In the case of conversions, this means that you must wait five years before taking a qualified withdrawal on converted funds unless you are older than 59 1/2.

Portfolio growth, inflation and your other income may affect your actual tax liability. Consider matching with a financial advisor who can help you make more accurate calculations for your goals.

The Bottom Line

By converting your 401(k) into a Roth IRA, you can entirely avoid having to take RMDs and paying taxes on them. However, this will trigger up-front conversion taxes. The closer you are to retirement, the more likely it is that those conversion taxes will swamp any benefits.

Tips On Managing Your RMDs

• Whether you would like to maximize portfolio growth, have multiple streams of income or want to leave assets in place for your heirs, minimizing RMDs is often an important part of retirement planning. Here are six strategies that can help make that happen. 

• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

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